Navigating a top-heavy stock market

Good morning. Inflation is still running out of control in at least one area: executive comp. The Financial Times reported yesterday that CEO pay at S&P 500 companies is up 12 per cent this year. I worry less about this from the point of view of equity than from the point of view of rationality. The relationship between executive skill and company performance is not very well understood. Faced with this, boards pay CEOs extravagantly in order to create the appearance of leadership excellence. The worry is that the CEOs start to believe their brains are as big as their pay cheques. Know a CEO who is worth every penny? Email me: robert.armstrong@ft.com.

The concentration game

Strong performance in the stock market is more and more concentrated in a few stocks, and more and more people are worried about it. In the Wall Street Journal over the weekend, Jack Pitcher noted the eerie lack of volatility in the S&P 500 hid the fact that its smooth upward march was driven by just a few names. He quotes Steve Sosnick of Interactive Brokers:

“If you’re very top heavy, it papers over a lot of other issues and can mask what’s going on under the surface,” Sosnick said. “The markets have been driven much more by greed recently than by fear. The problem is that the longer that goes on, the more fragile it becomes.”

Pitcher notes that the equal-weighted S&P 500 is down over the past month or so. But the outperformance of the market-weighted index has been building steadily since March of last year. Not only the equal weight, but small cap and non-US indices have been left behind:

I remain unsure about how worrisome this really is. We are in a good environment for equities: the economy is growing nicely, earnings are rising, and inflation appears to be falling again, clearing the way for the central bank to lower interest rates before long. And, the last month aside, it is surely worth keeping in mind that in the past 15 months, while the average stock has underperformed the big tech stocks by a lot, it has performed quite well in absolute terms, with an annualised real return of eight or nine per cent, above the historical average (more when dividends are included). It may make sense to worry about whether the staggering performance of Nvidia and the rest of big tech can continue, but it is premature to suggest that the rest of the index is falling apart.

Yes, a resurgence of inflation or a slowdown in consumer spending could shake things up. But that would be true even if the market was less concentrated.  

Interestingly, the concentration argument can be turned on its head. One might suggest that high concentration reflects the fact that the average stock is ripe to do better. Jim Paulsen, who writes the Paulsen Perspectives substack, makes this case. He thinks that the equal-weight index has not performed well because Fed has kept rates so high. Every US bull market since the middle of the last century — until this one — has started after the Fed has begun cutting rates, he notes. While the big tech stocks have not waited for the Fed’s OK to start rallying, the rest of the market has. When the Fed relents, therefore, the market should broaden and the rally continue. 

Paulsen points out that historically the relative performance of the equal-weight index is inversely correlated with the direction of interest rates (thought the relationship comes and goes a bit). His chart:

A similar pattern holds for small caps, dividend payers, and defensive stocks. Paulsen does not speculate about why this should be, but small caps tend to be more indebted and therefore rate sensitive, and defensives and dividend payers are bond substitutes that underperform when bonds offer more yield, particularly real yield. 

Paulsen’s argument is intriguing, but has a cake-and-eat-it character that makes me a little jumpy. The fact that the market has risen strongly despite higher-for-longer rates shows that this cycle is not like previous ones. Assuming it will start acting like previous ones after the Fed cuts seems a bit too optimistic. 

More on American exceptionalism

Last week I wrote about how, in the last fifteen years or so, American stocks can’t seem to lose and emerging market stocks can’t seem to win. This elicited two very interesting and very different responses.

Sahil Mahtani of the asset manager Ninety One wrote to argue that much of the underperformance of the emerging market indices is attributable to changes in the composition of those indices, changes that (if all goes well) will not repeat. He sent along the below chart which breaks down the 2011-2021 performance of various indices into changes in revenue, margins, exchange rates, and what he calls “net issuance”:   

As the chart shows, emerging market results were dragged down badly by net issuance, which is changes in the index’s denominator. It includes the impact of companies entering and exiting the index through IPOs and M&A, buybacks, secondary issuance, and changes in the index provider’s weightings.

The key swing factor for EM net issuance, Mahtani says, is changes in the China indices. The inclusion of American depositary receipts, onshore China “A” shares, and MSCI adding to China overall weighting in its EM index. Mahtani writes: 

Stocks entered the index at high valuations and then derated. For instance, ADRs entered MSCI China at 27x earnings in 2015 and then derated to 12x earnings by 2022. We also had a lot of expensive IPOs. Both were borne out of a particular liquidity and geopolitical environment that is unlikely to repeat itself going forward. Recent data suggests that “net issuance” is a third what it was at the peaks of the 2010s…

To put it simply, China’s derating hurt the EM index not just because China derated, but because the EM index ‘acquired’ China at high multiples to begin with.

in his Capital Wars substack, Michael Howell of Crossborder Capital wrote that my focus on the price/earnings valuation gap between American and emerging market indeces was mistaken. He thinks emerging market share prices move on capital flows, and buying them because they look cheap on a P/E basis is a mistake.

Howell points to the fact that the periods in the 90s and in mid-2000s in which EM shares did outperform coincide with big cross-border inflows to Asia and emerging Europe: 

When analysing markets from a macro perspective, Howell thinks that the key is to think of a market’s valuation as a function of three things: how much of investors’ portfolios is allocated to equities, the level of cash-like liquid assets available to invest, and corporate profitability. Here is his algebraic expression of that idea (P = market price, E= market earnings L = liquidity, GDP = gross domestic product):

The numerator on the right hand side expresses the idea that equity prices are a function of how much cash-like stuff is sloshing around the system and the proportion of stocks investors want in their portfolios. As investors try to rebalance away from cash (a futile exercise at the market level, because the cash does not disappear when it is used to buy stocks), prices are bid up and valuations rise. 

I’m sympathetic to this idea, which I have called the “hot potato theory”. There is little doubt that the high valuation of US assets has much to do with the fact that America is a uniquely accessible haven for global capital. But while capital flows often cause valuation differentials, it also makes sense to me that sometimes valuation differentials should have an effect on flows, particularly when those differentials become extreme.  

Why do we buy any security? Mostly to get paid. A price/earnings ratio can be thought of as a measure, not totally unlike a bond’s yield, of what a stock pays or might pay, right now. Turn a P/E ratio upside down, in other words, and you have an earnings yield. At some point, if P/Es in one sector or region fall far below those in another, and the divergence is not explained by economic fundamentals, people will move capital to chase those bargains.

This is not an argument that the valuation gap between the emerging world and the US will close. It is just an argument that it cannot keep widening forever. 

One good read 

The view from Arboleas.

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